January 8, 2024
IRS continues to focus on the proper location of sell-side transaction costs in a ruling granting targetís request to make a late success-based fee election
In PLR 202349003, the IRS granted a privately held corporation an extension of time to make the safe harbor election under Revenue Procedure 2011-29 for a success-based fee paid upon the completion of a merger.
This Tax Alert is one in a series discussing recent IRS rulings involving the proper entity to take sell-side transaction costs into account. For more in the series, see Tax Alerts 2023-0572, 2023-1156 and 2023-1632.
Taxpayer submitted a request under Treas. Reg. Sections 301.9100-1 and -3 (9100 Relief) for an extension of time to make a safe harbor election (Election) under Revenue Procedure 2011-29. The Election generally allows eligible taxpayers to treat 70% of a success-based fee as non-facilitative of a transaction (i.e., deductible or amortizable) and the remaining 30% as facilitative of a transaction (i.e., capitalizable).
Taxpayer was a privately held corporation that uses an accrual method of accounting on a calendar-year basis. Taxpayer and Buyer entered into an agreement (Merger Agreement) whereby Taxpayer agreed to be acquired by merging with a domestic corporation (Merger Sub), a wholly owned subsidiary of Buyer (Transaction).1 Taxpayer survived the merger and became a wholly owned subsidiary of Buyer. The Transaction was treated as a taxable acquisition of Taxpayer’s stock by Buyer for US federal income tax purposes.
No selling shareholders (Sellers) had a majority controlling interest in Taxpayer before the Transaction. Further, there was no pre-existing agreement among Sellers that enabled one or more Seller to effectively control the sale of Taxpayer stock.
Merger Sub did not engage in any activity other than to effectuate the Transaction and did not issue debt to effectuate the merger. Further, Taxpayer's funds were not used to acquire Taxpayer's stock; Taxpayer did not assume Merger Sub or Buyer's debt; and Taxpayer did not incur debt related to the Transaction.
Engagement with financial advisor
Before the Transaction, “Company” entered in an engagement letter with a financial advisor (Financial Advisor) to perform several financial advisory services on Company's behalf in relation to a possible transaction.2 In exchange for the services, Company agreed to pay Financial Advisor a contingent fee equal to a percentage of the aggregate value of the Transaction at close in cash or out of other available funds (Success Fee). Upon close of the Transaction, Financial Advisor issued an invoice to Company for the Success Fee.
Taxpayer asserted that the engagement letter referenced “Company” in error and the engagement letter and invoice should have referenced “Subsidiary,” a wholly owned subsidiary of Taxpayer and a member of its consolidated group. According to Taxpayer, Subsidiary was obligated to pay the Success Fee. The Merger Agreement, however, indicated Buyer was obligated to pay (or to cause Taxpayer to pay) the Success Fee and other unpaid company transaction expenses. Taxpayer directly paid the Success Fee by wire transfer from its checking account.
Historic tax advisor and missed election
Taxpayer hired its previous advisor (Historic Advisor) to prepare its return for the tax year in which the Transaction closed, but Historic Advisor did not inform Taxpayer about making the Election under Revenue Procedure 2011-29. As a result, Taxpayer failed to make the Election, representing that it relied on Historic Advisor’s treatment of the Success Fee.
The IRS granted the Taxpayer's 9100 Relief request to make a late Election under Revenue Procedure 2011-29 after reviewing the requirements under the 301.9100 regulations, transaction cost regulations under Treas. Reg. Section 1.263(a)-5 and legal entity location considerations. Please refer to our previous Tax Alerts in this series for an overview of the 9100 Relief requirements, transaction cost regulations applicable to success-based fees, and Revenue Procedure 2011-29.
In analyzing whether Taxpayer qualified for the Election, the IRS considered the rules under Treas. Reg. Section 1.263(a)-1(e)(1). Treas. Reg. Section 1.263(a)-1(e)(1) requires commissions and other transaction costs paid to facilitate the sale of property to be capitalized and used to reduce the amount realized by the seller in the tax year in which the sale occurs. These costs are not currently deductible under IRC Section 162 or IRC Section 212. As such, the IRS reasoned that “commissions and transaction costs that are paid to facilitate a sale reduce the amount realized, and are, therefore, not also covered by [Treas. Reg. Section] 1.263(a)-5, making [Revenue Procedure] 2011-29 also not applicable.”
Further, the IRS considered the application of the "direct and proximate benefit" test. Particularly, the IRS noted that for a taxpayer to deduct a cost under IRC Section 162, the expense must be "directly connected with" or have "proximately resulted from" a taxpayer's business activity. Citing to Deputy v. du Pont and other seminal cases in this area, the IRS observed that, in related-party scenarios, courts generally focus on the connection of the expense to the respective business of the parties when determining which party should take the cost into account.3
The IRS noted that increased scrutiny is given to whether an expense is that of a corporation or a controlling shareholder but acknowledged that expenses can be properly taken into account by the target corporation based on the language in Treas. Reg. Section 1.263(a)-5. Citing INDOPCO, Inc. v. Commissioner, the IRS remarked that it has not generally asserted that costs directly paid by a non-majority controlled public target corporation must be treated as the costs of selling shareholders and not as the costs of target corporation.4
After reviewing the facts and representations made by Taxpayer, the IRS ruled Taxpayer acted reasonably and in good faith and met the requirements for 9100 Relief. The IRS granted Taxpayer a 60-day extension from the date of the ruling to elect the safe harbor for the Success Fee.
Like the prior rulings in this Tax Alert series, this ruling demonstrates the IRS's continued scrutiny on the location of transaction costs, particularly on the sell-side.
Although the IRS did not explicitly say the Taxpayer properly took the Success Fee into account, it implicitly agreed by granting 9100 Relief. Significantly, the IRS remarked in a footnote that none of the Sellers were considered a controlling shareholder. This would seem to imply that an important factor in the IRS's evaluation of whether costs should be located at the selling shareholder is whether the selling shareholder has significant control over the target. This position is also consistent with the historic IRS position as described in the PLR that it “generally has not asserted that costs directly paid by a non-majority controlled public target company must be treated as the costs of selling shareholders so as to preclude a [IRC Section] 162 deduction by the target company.” This follows the conclusion reached in PLR 202308010 where 9100 Relief for a missed Revenue Procedure 2011-29 election was denied due to, in the IRS's view, the success fee benefitting the controlling private equity seller rather than the target.
The IRS continued its focus on the "direct and proximate benefit" test, which some may not agree is the standard to determine whether Taxpayer properly took the Success Fee into account. We continue to believe the better test to determine the proper location of transaction costs is a facts-and-circumstances analysis including (i) whether the taxpayer had a legal obligation to incur the expense; (ii) whether the taxpayer bore the economic burden of the expense; and (iii) whether the taxpayer benefitted from the expense.
As this is an apparent area of IRS focus, taxpayers should carefully examine their specific facts and circumstances when determining which party to a transaction is the appropriate entity to take transaction costs into account. Most importantly, this determination is critical to making a valid safe harbor election under Revenue Procedure 2011-29 for success-based fees. Further, timely filing of the safe harbor election under Revenue Procedure 2011-29 is critical as seeking 9100 Relief provides the IRS an opportunity to challenge the location of transaction costs.
1 Merger Sub and Stockholder Representative (on behalf of Sellers (defined within this Alert)) were also parties to the Merger Agreement.
2 The relationship between Company and Taxpayer is unclear from the PLR.
3 Deputy v. du Pont, 308 US 488, (1940).
4 Rink v. Comm'r, 51 T.C. 746, 751 (1969) (referencing du Pont, supra, in stating that "[u]nder the general rule [prohibiting a deduction for paying the expenses of another], not even a majority shareholder is entitled to deduct payments of the corporation's expenses").